The Opportunity in Small Caps

Small Cap stocks received a nice jolt in November when unexpected election results sent the Russell 2000 Index soaring. Currently up 19.08% year-to-date,* the sector has been a beneficiary of the President-Elect’s proposed policies. While some believe this rally could fizzle, we disagree and believe it will continue into the New Year, well past the new Administration’s inauguration—and here’s why.

With a Republican government, the GOP will do everything they can to fiscally stimulate GDP growth through lower taxes and heavy U.S. spending, so interest rates will see continued upward pressure helping the U.S. dollar to remain firm.

Due to the stronger U.S. dollar, earnings at large, multinational companies will be under pressure versus small U.S. companies, which will benefit from a reduction in corporate tax rates, so investors will want to shift to better earnings streams.

Credit spreads will continue to be favorable thus encouraging a higher risk appetite with all of this stimulus.

Small Caps have a higher concentration of financial stocks and with the upward movement in interest rates, the steeper yield curve, the ramping of the U.S. economic growth, the reduction in financial services regulation and red tape, and the large cut in U.S. corporate income tax rates, financial services earnings could accelerate at a rate that hasn’t be seen in decades.

Looking at the last 30 years of data shows that Small Cap P/E multiples are not expensive on a relative basis versus Large Caps.

(The Leuthold Group)

Finally, the November to April timeframe has typically been a seasonally strong timeframe for Small Cap performance with the majority of their annual returns happening during this window of time. Given the tailwinds mentioned above combined with the seasonal effect, I wouldn’t want to be a Grinch and not own Small Caps today.